Estimating the size of the market, and then predicting how much revenue the startup can achieve and at what growth rate is indeed a tricky exercise. But going wrong on this could either kill your company, or if in a rare case you have underestimated your revenues, you may end up diluting more equity at a funding round than would have been necessary.
It is therefore very, very critical that entrepreneurs focus on working and reworking on the market size and revenue potential based on sound assumptions and with minute detailing.
Many startups make the mistake of taking broad brush reports from large consulting or research firms, and estimate the size of their market on the basis of those reports. Often we hear entrepreneurs mention “According to Gartner, healthcare is a 80 bn USD industry with a 23% growth rate”. Now, while this could be broadly true, for an investor, and even for the startups, these figures have little relevance. Here’s why…
In most market segments, the investors would be broadly aware of the scale potential. At a startup stage, investors will most likely invite a startup for a meeting only AFTER they have assessed that the concept does have a potential to address a large market. Hence, stating the obvious, especially in segments that are very obviously large does not add any value. E.g. For a education domain startup, highlighting in minute details the number of number of schools, number of students and growth rate in India is wasting precious time in the first meeting with investors. Assume that investors who are meeting a startup in the education space know the potential of the opportunities in the domain.
How then do you estimate the market potential? Simply, by being specific about your segment and making some assumptions on the specific segments and the revenues per customer/consumer. E.g. Instead of saying education in India is a USD 18 billion market, for a premium ‘home tuitions startups’ it will be prudent to state “With over 250,000 students in the top 10 cities in schools with fees above Rs.10,000 a month, at Rs.2500 per student, the market potential is roughly over Rs.500 – Rs.600 cr. P.a. At an all India level, the same translates to a market potential of well over Rs.1000 cr.
Some points to consider when estimating market potential
- Clearly define what problem you are solving… and for whom – this will give you a good idea of the number of customers with that problem in the geographies that you plan to be available in.
- Estimate the practical reach e.g. while there may be a 100,000 people in your target audience spread across 50 cities, you may want to take the top 5 or top 10 cities and see how many people you have within your target audience. This of course gives you the total market potential IF 100% of potential customers were to buy.
- Now, apply some filters i.e. ability to pay, ability to reach via media, etc. E.g. while there may be 60,000 potential customers in the top 10 cities you identified, and you may be panning to use a combination of media, if the total reach of these media vehicles is 50%, the total potential of the market is really 30,000 customers.
You could also apply some price filters to test the elasticity of the demand in comparison to price. I.e. work up alternate scenarios to reflect the increase / decrease in demand in case the price were to be moved up or down… and then evaluate which scenario makes a better business case. [Note: For different situations you may have very different parameters for a good business case. In some cases, rapidly acquiring customers, even if margins are lower, would be a key criteria… often relevant in new concept that make sense for the first mover to ‘land grab’ and lock in potential customers on whom profitability can be increased later.
- Now, if the product is of a repeat purchase nature, you would need to make some assumptions on the number of times the customers would buy the product / service in a year. In doing this, it is critical to map the reality or in case of new product categories, to do some qualitative and/or qualitative research to validate your assumptions on the number of repeat purchases within a year.
- All the above, and perhaps some more as relevant to your category/product/service, will need to be worked and reworked often to arrive at what seems like a practical market estimation.
How do you estimate your revenue and growth? This is a rather tough part, and the accuracy of these guestimates is largely dependent on how accurate your assumptions are.
Many entrepreneurs make the mistake of projecting revenues as a % of the market potential. Often we hear entrepreneurs state “Even if we were to capture just 2.5% of a Rs.1000 cr market, we are targeting a revenue of Rs.25cr in year 2”. This is obviously an oversimplification and without any basis for how the sales plan will be implemented.
To prudent way of arriving at a estimation of revenue is to build a business case ground up. I.e. how much revenue are you expecting per customer, how many customers can you get, how much does it cost to get each customer, etc. At the startup stage, it is important to do a month-by-month detailing of how you see the customer base increase based on what specifically you plan to do in your marketing & sales plan. Needless to say that this is not a one-time exercise, and you will keep reworking on this till the business case starts making sense.
While doing month-by-month revenue estimation, if you have multiple revenue streams, then make the revenue estimates for all the revenue streams, which then total up to make the overall revenue for the company. E.g. if you are starting a chain of restaurants, you may want to break up the revenue by breakfast, lunch, snacks and dinner as these would cover different dynamics of your restaurant business. Similarly, if you were doing an ad-supported Freemium product online, you would like to estimate separately your revenues from ads on the free downloads and the subscription from the paid downloads.
Do remember that this is just a guestimate… i.e. a well-thought-out estimate. This is just a reflection of how YOU expect the market and the world around it to behave. And because there are no guarantees that the world will behave as you predict it to, it is prudent to be very, very conservative with the revenue estimates. If you are too optimistic, you are likely to allocate a proportionate marketing investments behind the revenue growth… and if for whatever reason the revenues do not happen as you have predicted, you will have a sufficiently fierce problem on hand.
|Note:In many a startup scenarios, revenues may NOT be the key parameter of progress. E.g. in a startup which is establishing a new technology, proving the concept and the business model may be the main objectives in the startup stage.|
Do remember that your growth and revenue numbers should be mapped to the marketing plans and marketing investments, and should be rooted in reality. “We are smarter and we know social media marketing really well and hence our customer acquisition cost is much lower than others” is not a statement that investors would be keen to bet on [though if you state that they would be keen that you demonstrate your skills in lower cost customer acquisition 🙂 ].
As one of my mentors had said “See the film in your mind… for a startup, it is critical to be very clear on what specifically is going to happen on the marketing front, product front and sales front in which month and therefore what revenue and customer numbers that will likely translate into”.
- Try to achieve higher conversions than comparable others in the market, but estimate much lower conversion. This way, even if you do not do better than market average, your plans don’t go awry.
- Validate your assumptions – validate your assumptions – validate your assumptions…. Again and again and with multiple sources. Going wrong in assumptions can be disastrous, even if the rest of the components of your business do well. E.g. if you assume a 0.5% conversion, but it actually turns out to get 0.3% conversions, you may be off by a considerable margin in your profitability and may also run out of cash sooner.
- Identify the key ratios that you need to measure. E.g. Gross margins, cost of customer acquisition, headcount per ‘unit’ [i.e. could be a set of customers], etc.
Key points to remember
- Be conservative in revenue estimates
- Validate your assumptions
- Detail out the revenue plan on a month-by-month basis, and separately for each revenue stream